Absolute veto or limited discretionary power?

Article by

Agreements will often contain a provision that something can only be done with the consent of a particular person.

Does this mean that the person has an absolute veto over the relevant action? Or are there any limitations on the way in which the person may exercise their power?

Watch out for option agreements

In a recent case[1] the directors of Adoreum Partners (Adoreum), a business development consultancy, claimed that they were entitled to exercise options over shares in a luxury watch retailer (Watchfinder).

The companies had entered into a service agreement under which Adoreum would provide various services, including introducing new investors to Watchfinder. In particular, Watchfinder were seeking investment from a high end watch brand, Richemont.

Although Richemont were not willing to invest in Watchfinder, another company that Adoreum introduced did provide significant investment. Despite this, Watchfinder decided to terminate the service agreement with Adoreum on the basis that they had not managed to get Richemont on board.

Adoreum then attempted to exercise their share option. This was refused by Watchfinder, who pointed to a clause in the option agreement which read: ‘the option (to acquire 5% of the company’s shares for £150,000) may only be exercised with the consent of a majority of the board of directors of the company’. Watchfinder said that as the required consent had not been given, the share option could not be exercised.

Adoreum challenged Watchfinder and requested copies of board minutes and relevant evidence that set out how the decision had been reached. Watchfinder refused to provide any information and repeatedly pointed to the clause. At the time, following a recent sale of part of the Watchfinder business, the value of the shares subject to the option was £1 million.

Unconditional right of veto?

The court considered whether Watchfinder had an unconditional right to veto the exercise of the option but concluded it did not. If the clause was interpreted in this way then the option would be meaningless and the grant of shares would have been entirely in the company’s hands. This would never have been the intention of the parties when they entered into the agreement.

Watchfinder had relied too heavily on what they believed was a right to outright veto the deal.

However, the court decided the clause in the option simply gave Watchfinder a discretionary power which was subject to implied limits on how that discretion should be exercised.

Limits on discretionary power

Directors are subject to a duty to exercise discretion in a way which is not ‘arbitrary, capricious or irrational’. So the Watchfinder directors had to follow a proper process which took into account significant points but did not focus on irrelevant considerations.

A key issue for Watchfinder should have been the underlying commercial arrangement between the parties. This was essentially for Adoreum to find an investor that would meet the needs and demands of Watchfinder going forward. Therefore, before deciding whether to permit the exercise of the share option, Watchfinder should have considered the impact Adoreum had on the business. Had they significantly contributed to the growth and value of Watchfinder?

The court decided that the investor that had been brought on board by Adoreum, albeit not the one Watchfinder expressly desired, had contributed to the value of the company in a significant way. Watchfinder should have given more weight to this in its deliberations.

Going further, the court criticised Watchfinder for not showing any considered exercise of its discretion. Only the managing director spoke at the board meeting and no other directors produced evidence at the hearing. The directors had been under the impression, incorrectly, that the company had a right of absolute veto over the share option. The board had also been fixated with the fact that any investment from Richemont had not been delivered and there was no consideration of the large investor that was secured by Adoreum.

So Watchfinder had focused on all the wrong issues and proceeded without exercising any real discretion at all.

Adoreum succeeded in a claim for specific performance.

Implications

Adoreum were successful in this claim but they had to contend with the uncertainty and costly nature of litigation. The result could also have been very different had Watchfinder followed a more calculated decision making process.

To avoid the lengthy litigation, it would have been preferable if the clause was omitted from the outset, or at least qualified in some way. For example, the requirement to introduce a specific investor (Richemont) before the option could be exercised would have prevented any ambiguity.

Any decision making process should be documented to show the range of factors considered and the reasoning behind the decision. Contractual parties should also be wary of relying on what appears to be an absolute right of veto in case it is construed as a discretionary power subject to implied limits.